Why we invest inKronos Worldwide

Important notice: This document describes the process of how we analyse a company, in our internal assessments prior to making an investment decision. This document is prepared by the fund managers of Kempen (Lux) Global Small-cap Fund (‘the Fund’), managed by Kempen Capital Management N.V. (‘Kempen’). The Fund currently holds shares in the subject company. Please read the disclosure and disclaimer at the end of this document.

Date: January 2016

In September 2015, the share price of Kronos Worldwide caught our attention as it had declined more than 50% since the start of the year. The share price had dropped as much as 70% compared to January 2014. After extensive analysis we believe there is significant ’hidden value’ in Kronos. As value-driven long-term investors we concluded that Kronos was ripe for investment. Below we explain why we are positive about Kronos in six steps.

Source: Factset

Step 1: Kronos in a nutshell

Kronos is a producer of titanium dioxide, which is a white pigment used to whiten things, from your computer mouse to the paint on your wall. Over 50% of the world’s titanium dioxide goes into paint and coatings, but it is also used for plastics, paper, toothpaste, sunscreen and cosmetics. There is no really effective substitute for titanium dioxide; no other white pigment has the physical properties for achieving comparable brightness and opacity at a similar cost price. In other words, titanium dioxide is all around and most likely here to stay. We even see growth opportunities for new applications such as 3D printing.

Source: Kronos Worldwide, annual report 2014

Step 2: Industry recovering from oversupply

There are only a few producers of titanium dioxide worldwide. Kronos is not the largest at a 9% global market share, but it is market leader in several European countries (including Germany). Other major players are Chemours (formerly part of DuPont), Huntsman, Tronox and Cristal. After peaking in 2011, the price of titanium dioxide has been declining, mostly due to overcapacity caused by Chinese players entering the market in the last six years. Lower prices have been putting pressure on earnings. This explains the drop in the share price. However, we believe that the supply-demand ratio is improving, as many smaller Chinese producers are shutting down capacity and some Western players have been closing plants. In the second half of December 2015, several producers announced price increases effective as of January 2016, which is also a positive sign.

Step 3: Strong financial position

As long-term investors, we look at Kronos’ ability to survive periods of weaker earnings. We have therefore spent time assessing its balance sheet and cash flow statements. Compared to its competitors, Kronos has one of the most solid balance sheets with a relatively modest net debt position. In contrast, Chemours and Huntsman in particular face much higher debt levels. Kronos also does not need to repay its debt before 2020.

Step 4: Significant hidden asset value

Looking closer at the balance sheet, we believe there is significant hidden asset value. Kronos was founded in 1916 and most of its production facilities (land, buildings and installations) were bought many decades ago. These assets are valued on the balance sheet at historical cost price, minus depreciation. We estimated the replacement value of these facilities, i.e. what would it cost to build similar capacity today? In addition to its own production facilities, Kronos has a joint venture with competitor Huntsman and a mine in Norway. The latter has an infinite concession and about 50 years of reserves to supply its European business with raw materials. According to our analysis, these assets are in the books at levels well below their market value. Lastly, Kronos has losses from the past that can be used to offset taxes going forward and these are also not on the balance sheet. When we add this all up, we estimate the replacement value of Kronos to be significantly higher than the current stock price (Kronos stock price closed at $5.65 on 5 January 2016, the time of writing). However, the question with this type of investment cases is always whether the value will ever be unlocked. There are a few possibilities for this we take into account. First of all, we believe Kronos has a large amount of unused land, which could be sold to unlock part of the hidden value. Secondly, the replacement value will be more relevant as soon as the market recovers and there is a need for new capacity. Nor do we rule out a bid being made for the entire company, by either a financial or industry player.

Step 5: Earnings power value

Besides looking at the value of its assets, we valued Kronos based on its ability to generate earnings. Given the cyclical nature of this business, it makes sense to look through the cycle. In other words, we examined the earnings Kronos can generate in an average year. Based on its existing production capacity and average historical profit margins, in our view Kronos also trades at a significant discount to its earnings power value.

Step 6: Large-scale insider buying

We are not the only ones who believe there is a lot of value in Kronos. The management of Kronos, some of whom have been with the company since the 1980s, has been buying shares in the last few months. The Chairman has even invested in excess of USD2 million since August 2015, thereby more than doubling his position in the stock.

Source: SEC filings, from 10 August 2015 to 18 December 2015

Kronos is backed by a billionaire family, which holds 80% of the shares. This limits the percentage of the company that is freely traded on the stock exchange, as a result of which Kronos is overlooked by many investors and not well covered by equity analysts. This offers opportunities for active small-cap investors such as ourselves.

Disclaimer

This document is prepared by the fund managers of Kempen (Lux) Global Small-cap Fund (‘the Fund’), managed by Kempen Capital Management N.V. (‘KCM’). The Fund currently holds shares in the subject company. The views expressed in this document may be subject to change at any given time, without prior notice. KCM has no obligation to update the contents of this document. As asset manager KCM may have investments, generally for the benefit of third parties, in financial instruments mentioned in this document and it may at any time decide to execute buy or sell transactions in these financial instruments. The information in this document is solely for your information. This document should not be considered to constitute an investment recommendation and it is not intended as an offer or a solicitation to buy or sell any financial instrument mentioned in this document. This document is based on information that we consider reliable, but we do not represent that it is accurate or complete, and it should not be relied on as such. The views expressed herein are our current views as of the date appearing on this document. This document has been produced independently of the company and the views contained herein are entirely those of KCM.